Safer Strategies for Leveraged Investing

With stocks soaring and interest rates parked at historic lows, the last few years have been boom times for leveraged investing. According to data from FINRA, margin accounts have ballooned from less than $200 billion in February 2009 to $355 billion in December 2012. (The peak was $416billion, in July 2007.)

Yet leveraged portfolio strategies retain their bad reputation among many advisors, frowning on the speculative practice of using margin to try to turbocharge returns. "My advice to clients over my 20-plus years has always been to never buy on margin," says Chris Parr, who heads Parr Financial Solutions, a wealth management firm in Columbia, Md. "You should not invest what you don't have."

Margin loans have a place - but that place isn't in the stock market, several planners say.

"We do use margin for bridge loans when buying and selling homes and other short-term loans," says Marilyn Gunther, founding partner of the Center for Financial Planning in Southfield, Mich., and a registered principal of Raymond James Financial Services, "but rarely if at all for the purchase of stock."

PLAYING THE PERCENTAGES

The long-term case for margin investing is straightforward. Even with two major bear markets in this century, large-cap U.S. stocks have annualized returns of 9.705% over the past 25 years and 10.808% for the past 30 years through 2012, according to Morningstar's Ibbotson subsidiary.

If clients can get margin loans at, say, 6% to buy stocks that will return 9% or more long term, results will be amplified. That's especially true if the interest payments provide tax deductions now while the returns, if and when they're eventually realized, are likely to be taxed at favorable long-term capital gains rates.

"On paper, the math works, especially in the low interest rate environment we are slogging through," says Laurie Renchik, a senior planner at the Center for Financial Planning.

But what about the dreaded margin call, which can cause stock positions to be called away during bear markets so that there's nothing in place for the subsequent rebound? It's true that investors who crowd the 50% margin limit are at higher risk for such setbacks. Clients who keep margin to lower levels - perhaps 15% to 20% of a portfolio's value - might still get higher returns by using leverage while reducing their margin call risk.

RISKY BUSINESS

Why the resistance to using margin, even in moderation?

"I believe that investors should not take more risk than they need to meet their goals," Parr says. "It is just as important, if not more important, to protect downside risk than to stretch for upside gain.

As he sees it, "This technique always eventually ends very badly, and greedy investors can get wiped out. The tech bubble comes to mind as a time when margin buying and use of leverage was widespread."

Tom Orecchio, principal at Modera Wealth Management in Westwood, N.J., adds that margin leverage is "your friend in an upward-trending market, but your enemy in a downward-trending market. Many - and I would venture to guess most - investors do not have the necessary patience to weather the short-term volatility that is exacerbated by margin."

Leveraging a portfolio with margin purchasing power is a strategy that's likely best reserved for investors with a high tolerance for risk, Renchik says.

"Generally, the clients I work with are more conservative," she says. "Over the years, I have found that my clients are most comfortable with reduced volatility and growth that is in line with asset allocation benchmarks."

DOUBTFUL DEDUCTIONS

What's more, the favorable tax aspects of investing on margin may not be readily available.

Margin interest is classed as investment interest, explains Marty Abo, who heads a CPA firm in Mount Laurel, N.J. The deduction by a non-corporate taxpayer for such interest is limited to the taxpayer's investment income.

"Clients often don't have the amount of interest and dividend income to offset it," he says. "That's especially true if they have a large portion of their portfolio seeking appreciation rather than current income."

The low yields in today's economy make it less likely that clients will have enough investment income to offset their margin interest, he adds.

"Clients also have to realize that no deduction is allowed for interest paid on a debt incurred or continued in order to purchase or carry tax-exempt bonds," Abo says. Many planning clients have extensive holdings of municipal bonds and muni bond funds, making it even more difficult to get a full deduction for their margin interest.

With or without favorable tax treatment, using margin means borrowing money, which may not be a prudent way to acquire a volatile asset like stocks.

"Margin works best with assets that are not priced frequently, appear to have stable values and are expected to go up over long periods of time - like a house," Orecchio says. "Stocks do not fit that description - not in a world of 24-hour news, CNBC and high-frequency trading."

CONVENIENCE FACTOR

When might margin make more sense? "As overdraft protection or to cross trades," Orecchio says. "If a client does not have sufficient cash to cover a check written against the portfolio, such a check would put the account on margin rather than bouncing the check."

In terms of crossing trades, Orecchio says, rather than waiting for a sale to settle, an investor can sell and then buy. "In a worst case, it would put you on margin for a few days," he notes.

"This is no longer an issue at most custodians, but it might be an issue for individual investors crossing trades on different platforms. It would keep the investor from being out of the market as trades settle," he says.

SHORT-TERM FINANCING

Mitch Reiner, chief operating officer and an investment advisor for Capital Investment Advisors in Atlanta, agrees that margin can be a valuable short-term financing tool.

"Clients have easy access to funds at competitive interest," he says. "It's something some clients have used when closing the sale on a building or on a small business."

Recently, Reiner says, a client needed $700,000 to buy out a partner's share in a real estate property. His client was expecting a substantial amount of income within six months from earnings and a bonus, but he was low on cash.

"He had $2.5 million in a brokerage account," Reiner says. "Instead of selling stocks to raise the cash, he borrowed the $700,000 on margin. The interest rate he's paying is reasonable, at 6%, and he got the loan quickly, without going through any underwriting."

With $2.5 million in the account, a $700,000 loan equals 28% margin. Reiner says that his client does not have much risk of a margin call with that amount of leverage. And in this case, he says, keeping money in stocks has turned out to be a good move.

Donald Jay Korn is a Financial Planning contributing writer in New York. He also writes regularly for On Wall Street.